May You Live in Interesting Times

Understanding Risk

Regardless of which side of the political spectrum you land on, we can all agree we live in ‘interesting’ times. Such turmoil and uncertainty, regardless of source and nature, tends to cause market volatility. Many so-called investment professionals see volatility as a source of risk. One of the main questions asked of clients relates to how much volatility they can tolerate. But this is examining the very wrong thing when it comes to constructing an investment portfolio.

If your time investment horizon is short (e.g. months rather than years), then day-to-day or even month-to-month stock market fluctuations are irrelevant assuming you have properly allocated assets into short-term instruments like cash, CD’s and short-term bonds. If your time horizon is long—e.g. you have a retirement account you won’t be tapping into for years—then how much the stock market swings in the near term is again irrelevant. What matters is dividend payments and price appreciation over years, not days, weeks or even months.

The best question around risk is not, “…what is your emotional tolerance for market volatility?” but rather, “…do you know what you are doing?” If a professional money manager can’t tolerate short-term market movements—or guide clients to ignore such irrelevant events—he shouldn’t be in the business. Not knowing what you are doing is the primary source of risk for any undertaking whether it is investing in stocks, body surfing in the ocean, or caring for a sick child. Other true sources of risk include things like taking on excess leverage, being over-concentrated (having too much exposure to a given company or sector), and paying too much for a stock (purchasing a stock for far more than its intrinsic value).

Bottom line, when it comes to long-term investing (is there any other kind?), volatility is your friend, not your foe.

Taking Advantage of Volatility

While no investor can—nor do you need to be able to in order to create wealth via stocks over time— consistently predict short-term market movements, you can take advantage of them. At Coastwise we focus on owning high-quality dividend paying stocks and hedging them with conservative short calls when appropriate. So how does this investment approach take advantage of stock market volatility? Here are a couple key ways:

  • A well-diversified portfolio of dividend paying stocks may generate 100 or more dividend payments a year. This means that stock is consistently being purchased via reinvested dividends. When stock prices decline, a dividend paying portfolio naturally employs the powerful technique of dollar cost averaging. So not only are you buying more shares at lower prices, but those higher share counts in turn generate even larger dividend payments 90 days following. Thus, when you are a net investor via reinvested dividends, short-term volatility (in the form of price declines) actually works to your long-term advantage. This is not the case if you own just growth, or non-dividend paying stocks.

  • Options—which Coastwise generally sells as a means to hedge positions, generate income, or purchase a stock at a lower entry point—are priced based on a few variables, with overall volatility being an important one. As volatility rises, the price of options increases, and in turn the premium or income one can generate from selling options. Thus, not only do covered calls (the purchase of stock ‘long’ combined with the sale of a short call) provide some downside protection in a declining market, but volatile markets tend to allow the seller of calls to generate even more income than during calm markets. Specifically, if VIX (an important and now widely watched measure of volatility) increases as it did during certain events like the BREXIT vote last year, then option premiums get richer and one can earn higher income from option sales.

Political, economic, social, and other uncertainty can be unnerving. As humans we like to feel in control, we like the sensation of always ‘knowing’. But unpredictability is a reality of life, with the only question being to what degree. We have recently entered into what is likely a heightened period of uncertainty, and stock market volatility. Rather than fearing this, or being paralyzed by it (or worse yet selling long-term holdings until things become ‘clear’ again), look beyond the headlines to company fundamentals over the long term (your true stock holding time horizon). When you get away from incessantly changing headlines and focus on the long-term fundamentals, you will have a greater tendency to not take short-term action that could hurt your long-term finances. If you have the time and skill to take advantage of increased volatility—or can work with someone who has decades of experience navigating such waters—then so much the better. Let volatility be your ally not your foe; take advantage of it, don’t be the financial victim of ugly headlines and rapid market movements.

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